How Cryptomining Works (And an In-Depth Look at Blockchain)
In a nutshell, crypto miners verify the legitimacy of transactions in order to reap the rewards of their work in the form of cryptocurrencies. To understand how most cryptocurrency mining works in a more technical sense, you first need to understand the technologies and processes behind it. This includes understanding what blockchain is and how it works.
The first thing to know is that two things are central to the concept of blockchain: public key encryption and math. While I’m definitely a fan of the first, I’ll admit that the latter isn’t my strong suit. However, public key cryptography (aka public key encryption or asymmetric encryption) and math go together in blockchains like burgers and beer.
Traditional cryptocurrencies such as Bitcoin use a decentralized ledger known as blockchain. A blockchain is a series of chained data blocks that contain key pieces of data, including cryptographic hashes. These blocks, which are integral to a blockchain, are groups of data transactions that get added to the end of the ledger. Not only does this add a layer of transparency, but it also serves as an ego inflator when people get to see their transactions being added (chained) to the blockchain. Even though it doesn’t have their names listed on it, it often still evokes a sense of pride and excitement.
Breaking Down the Roles and Processes Within the Bitcoin Blockchain
There are several key components and processes involved in the creation of a blockchain. For this explanation, we’re going to use Bitcoin as our example:
Nodes. These are the individuals and devices that exist within the blockchain (such as your computer and the computers of other cryptocurrency miners).
Miners are the specific nodes whose jobs are to verify (“solve”) unconfirmed blocks in the blockchain by verifying the hashes. Once a miner verifies a block, the confirmed block then gets added to the blockchain. The first miner who announces to the rest of the nodes that they’ve solved the hash is rewarded with a cryptocurrency.
Transactions. A transaction is the thing that gets this party started — I mean, the cryptocurrency mining process rolling. To put it simply, a transaction is an exchange of cryptocurrencies between two parties. Each separate transaction gets bundled with others to form a list that gets added to an unconfirmed block. Each data block must then be verified by the miner nodes.
Hashes. These one-way cryptographic functions are what make it possible for nodes to verify the legitimacy of cryptocurrency mining transactions. A hash is an integral component of every block in the blockchain. A hash is generated by combining the header data from the previous blockchain block with a nonce.
Nonces. A nonce is crypto-speak to describe a number that’s used only once. Basically, NIST describes a nonce as “a random or non-repeating value.” In crypto mining, the nonce gets added to the hash in each block of the blockchain and is the number that the miners are solving for.
Consensus algorithm. This is a protocol within blockchain that helps different notes within a distributed network come to an agreement to verify data. The first type of consensus algorithm is thought to be “proof of work,” or PoW.
Blocks. These are the individual sections that compromise each overall blockchain. Each block contains a list of completed transactions. Blocks, once confirmed, can’t be modified. Making changes to old blocks means that the modified block’s hash — and those of every block that’s been added to the blockchain since that original block was published — would then have to be recognized by all of the other nodes in the peer-to-peer network. Simply put, it’s virtually impossible to modify old blocks.
Blockchain. The blockchain itself is a series of blocks that are listed in chronological order. Because previously published blocks can’t be modified or altered after they’ve been added to the blockchain, this provides a level of transparency. After all, everyone can see the transactions.
A Step-by-Step Look at the Crypto Mining Process
Okay, it’s time to take a really granular look at the cryptocurrency mining process and better understand how it works.
1. Nodes Verify Transactions Are Legitimate
Transactions are the basis that a cryptocurrency blockchain is built upon. So, let’s consider the following example to understand how this all comes together:
Let’s say you’re a crypto miner and your friend Andy borrows $5,000 from your other friend Jake to buy a swanky new high-end gaming setup. It’s a top-of-the-line computer that’s decked out with the latest gaming setup accoutrements. (You know, everything from the LED keyboard and gaming mouse to the wide multi-screen display and killer combo headset with mic.) To pay him back, Andy sends him a partial Bitcoin unit. However, for the transaction to complete, it needs to undergo a verification process (more on that shortly).
2. Separate Transactions Are Added to a List of Other Transactions to Form a Block
The next step in the crypto mining process is to bundle all transactions into a list that’s then added to a new, unconfirmed block of data. Continuing with the example of the gaming system transaction, Andy’s Bitcoin payment to Jake would be considered one such transaction.
By adding their transaction to the blockchain (once the verification process is complete), it prevents “double spending” of any cryptocurrencies by keeping a permanent, public record. The record is immutable, meaning it can never be manipulated or altered.
3. A Hash and Other Types of Data Are Added to the Unconfirmed Block
Once enough transactions are added to the block, additional info is added as well, including the header data and hash from the previous block in the chain and a new hash for the new block. What happens here is that the header of the most recent block and a nonce are combined to generate the new hash. This hash gets added to the unconfirmed block and will then need to be verified by a miner node.
In this case, let’s say you’re just lucky enough to be the one to solve it. You send a shout-out to all of the other miners on the network to say that you’ve done it and to have them verify as much.
4. Miners Verify the Block’s Hash to Ensure the Block Is Legitimate.
In this step of the process, other miners in the network check the veracity of the unconfirmed block by checking the hash.
But just how complex is a hash? As an example, let’s imagine you apply a SHA-256 hash to the plain text phrase “I love cryptocurrency mining” using a SHA-256 hash calculator. This means that the phrase would becomes “6a0aa6e5058089f590f9562b3a299326ea54dfad1add8f0a141b731580f558a7.” Now, I don’t know about you, but I’m certainly not going to be able to read or decipher what the heck that long line of ciphertext gibberish says.
5. Once the Block is Confirmed and the Block Gets Published in the Blockchain
On the crypto miner’s side of things, this is the time for celebration because the proof of work (PoW) is now complete. The PoW is the time-consuming process of solving the hash and proving to others that you’ve legitimately done so in a way that they can verify.
From the user’s side of things, it basically means that Andy’s transfer of a partial Bitcoin to Jake is now confirmed and will be added to the blockchain as part of the block. Of course, as the most recently confirmed block, the new block gets inserted at the end of the blockchain. This is because blockchain ledgers are chronological in nature and build upon previously published entries.
How These Components Work Together in the Blockchain Ecosystem
So, how does this ledger stay secure from manipulation and unauthorized modifications? All of the transactions for the ledger are encrypted using public key cryptography. For the blocks to be accepted, they must utilize a hash that the miner nodes on the blockchain can use to verify each block is genuine and unaltered.
Who Updates the Blockchain (and How Frequently)?
Because there’s no centralized regulating authority to manage or control exchanges, it means that the computers that mine that specific type of cryptocurrency are all responsible for keeping the ledger current. And updates to the blockchain are frequent. For example, Buybitcoinworldwide.com estimates that the Bitcoin blockchain gains a new block every 10 minutes through the mining process.
With a cryptocurrency blockchain, anyone can see and update the ledger because it’s public. You do this by using your computer to generate random guesses to try to solve an equation that the blockchain system presents. If successful, your transaction gets added to the next data block for approval. If not, you go fish and keep trying until either you’re eventually successful. Or you decide to spend your time and resources elsewhere.
Now that you understand what cryptocurrency mining is and how it works, let’s take a few moments to understand the attraction of cryptocurrencies and why someone would want to mine them.
In March 2014, the IRS stated that all virtual currencies, including bitcoins, would be taxed as property rather than currency. Gains or losses from bitcoins held as capital will be realized as capital gains or losses, while bitcoins held as inventory will incur ordinary gains or losses. The sale of bitcoins that you mined or purchased from another party, or the use of bitcoins to pay for goods or services are examples of transactions which can be taxed.9